For any of a variety of reasons, an entity, whether, for example, an individual or corporate entity, may seek to gain liquidity in relation to a business or assets in exchange for a stake in ownership, a loan or some combination thereof. Putting aside actually selling the asset that serves as the basis for the liquidity, several conventional arrangements accommodate such an entity, or a combination of entities—in certain circumstances.
In a typical scenario involving corporate entities, some companies can achieve a degree of liquidity by offering shares in the company privately or via a public offering. In such a case, the corporate entity (i.e., the company) gets liquidity in the form of cash from the sale of shares, in exchange for giving up a part ownership of the asset. In such a case, an investment in the company comes with risks to the investor that are not only related to the industry, but also to the company itself. Such risk may stem from the potential of mismanagement of the company, loss of key employees, and so on. Individuals, or funds, may purchase shares in a variety of companies in an attempt to offset any idiosyncratic risks attributable to individual companies. But, in the end, the investors risk is still a function of the individual performance of the companies of which he owns shares.
While many companies can gain liquidity by “going public,” some companies or other entities do not meet the investment community's requirements for going public. For example, in some situations, small business owners may desire to sell part of their business for diversification purposes or to raise capital to invest back into the business. This can be difficult with a small, privately held business. Capital markets are not open to the small businesses because of their small size and lack of accounting audits. So this path remains unavailable to small businesses, while being quite available to many larger businesses.
Small businesses can sometimes sell a stake, ranging from a minority stake to a 100% stake, to private investors or private equity firms, but they tend to sell at a relatively low price to earnings ratio. And, the terms of such investment can often be considered unattractive to the small business. For example, a certain amount of control of the small business may also be required in the exchange for capital from the investor. On the other hand, investors who might benefit through investments in these businesses do not have a convenient liquid way to do so. Typically, to buy into a small business an investor must go through a fairly involved and costly assessment and due diligence process. And selling the stake in the small business may also be a complicated and lengthy process.
Individuals may also have a desire for liquidity, as examples, to make investments or purchases, to pay down debt, and to fund college tuition. Typical approaches to gaining liquidity are loans, credit card purchases or cash advances. In some cases, individuals refinance or take a second mortgage on their real estate to pull cash out, or get an equity line of credit that makes liquid a portion of the equity in the real estate. These types of real estate-based liquidity approaches can carry a certain amount of risk.
With variable interest rates there is always an interest rate-based risk—i.e., the risk that the interest rate will increase during the term causing payments to increase. If the interest rate is fixed, that will not be an issue. However, with a fixed interest rate, the borrower does not get the benefit of interest rates dropping.
Aside from interest rate-based risk, there is market-based risk. With market-based risk there is a chance that the market value of the real estate will be decrease. Since real estate prices have historically been cyclical, market values will be more favorable to an owner at some points in time than it is at other points in time. In fact, since the value of the underlying real estate asset will change over time, it is possible that the real estate owner will have negative equity in the real estate at some points in time. In these cases, where the owner owes more than the real estate is worth. As a result of negative equity, refinancing options are generally unavailable and a sale of the property would require the owner/borrower to add cash to the sale proceeds to pay off the debt against the house.
Even when there is no negative equity, a market value that is lower than the owner's expectations can cause a significant financial impact. For example, if an owner presumed his house to have a market value of $1 M in three years, but sold the house three years later for 5% less, that is a $50,000 impact to that owner. Understandably, the risk of the market value of real estate going down can have a chilling effect on an owner's willingness to make liquid and use his equity. And even if the owner intended to preserve all of his equity for an eventual sale, e.g., to fund his retirement, having a lower than expected market value at the time of sale can represent an unmanageable risk. Thus, for many, the equity in their real estate is their largest asset and perhaps the intended source of cash for retirement, college tuition, and so on. A lower than expected market value can have a severe impact to such plans. This not at all addressed with conventional approaches to financing. There is no apparent way to effectively manage against market risk. This can be true for other assets, and not just real estate.
The above concerns can be equally shared in various commercial real estate contexts, perhaps more so than for an individual home owner. For example, a small commercial real estate owner, company or trust can be a holder of one or more properties, which could include typical commercial properties. As example, commercial properties could include retail space, office space, manufacturing facilities, condominiums or other properties. Holders of commercial property, whether large or small, have no apparent way to directly manage against market risk.